Focus on Not-For-Profits: Private Foundations Must Meet the 5% Annual Distribution Requirement While Ensuring the Long-Term Viability of Their Investment Portfolios

Contact Our Team

Private foundations face a challenge that other foundations and not-for-profit organizations do not. Perhaps the most significant of these is the requirement that private
foundations distribute 5% of the fair market value of their assets each
year.

February 5, 2015

Private foundations face a challenge that other foundations and not-for-profit organizations do not. Similar to many other not-for-profits, private foundations seek to maximize the return on their investment portfolios in order to ensure their long-term viability and to provide the resources to award grants to the organizations and causes they support. However, unlike other not-for-profits, private foundations simultaneously must comply with various IRS regulations that are unique to the private foundation environment. Perhaps the most significant of these is the requirement that private foundations distribute 5% of the fair market value of their assets each year.

As will be elaborated further in this article, this 5% requirement can cause a number of complications for private foundations, including wide fluctuations in grant distributions, less predictable receipts for the organizations supported by private foundations, and a decline in the value of investment portfolios during years in which equity markets perform poorly. Action steps that private foundations should consider in response to these challenges will also be discussed.

The 5% Minimum Distribution Rule

In general, Section 4942 of the Internal Revenue Code requires private foundations to distribute 5% of the fair market value of their assets each year. The intent of this requirement is to ensure that private foundations are serving legitimate charitable purposes and not merely acting as a means for the foundation’s contributors to avoid taxes on their investment earnings. Since private foundations are, by definition, supported by only a few donors, and private foundations pay only a small excise tax of 1% or 2% on investment earnings, it is conceivable that, absent a requirement for private foundations to make annual grant distributions, private foundations could be misused by wealthy individuals as a way to hold investments in a nearly tax-free environment.

Specifically, Section 4942 requires private foundations to distribute 5% of the fair market value of their non-charitable use assets for the current year by the end of next year. For example, a private foundation must distribute 5% of the 2014 average fair value of its assets by the end of 2015. Distributions for this purpose include amounts paid to accomplish the foundation’s charitable purposes, as well as reasonable and necessary administrative expenses. Non-charitable use assets include all cash and investments (based on an average of the monthly fair market values of these assets) as well as other assets (valued annually) except those held solely for charitable purposes. If a private foundation distributes more than 5% in a given fiscal year, the excess may be carried forward and applied against the distribution requirement for any of the next five fiscal years. The required distribution and carryfoward amount (if any) are calculated on Part XIII of the Form 990-PF, which is the tax return that private foundations are required to file.

If a private foundation fails to distribute the required 5% by the end of the subsequent fiscal year, it is subject to a 30% excise tax on the undistributed amount. If the required amounts remain undistributed, the foundation may be subject to an additional 100% excise tax on the undistributed amount.

Consequences for Private Foundation Investment Portfolios

Most private foundations are formed with the intent they will exist indefinitely. To do so, a foundation’s investment portfolio must earn a long-term rate of return that exceeds both the inflation rate as well as the 5% distribution rate. As a result, most private foundations invest heavily in stocks and other equity instruments, since historically equities have produced much higher long-term rates of return than bonds or debt instruments. As part of RubinBrown’s 2013 Not-For-Profit Economic Outlook survey, we reviewed the Forms 990-PF for 28 of the largest private foundations in the St. Louis, Kansas City and Denver regions. Our research indicated that, on average, private foundations invest 56.4% of their investment portfolios in stocks and equity instruments.

However, while equity instruments do generally earn higher rates of return than debt instruments, returns on equity investments are subject to much more volatility from year to year. To illustrate this, consider the total return (including capital and income) for the S&P 500 index for the last ten years, as displayed in the table below:

Calendar Year

Rate of Return

2005

4.91%

2006

15.79%

2007

5.49%

2008

(37.00)%

2009

26.46%

2010

15.06%

2011

2.11%

2012

16.00%

2013

32.39%

2014

13.69%

This volatility has several consequences for private foundations as they try to manage their grant distributions. First, in some years, the foundation’s investments may earn less than 5%. Private foundations are still required to distribute 5% of their assets even in years with poor returns, and thus it is possible that this distribution requirement could cause private foundation investments to decrease in some years. As can be seen in the table above, in three recent years (2005, 2008 and 2011), the return on the S&P 500 was in fact less than 5%.

Even if a strict application of the 5% distribution rate does not cause private foundation assets to decrease in a given year, the year-to-year volatility in equity portfolio returns could result in wide year-to-year swings in the distributions private foundations must make. This makes it more difficult for private foundations to make multi-year awards and undertake other forms of grant planning. Furthermore, many other not-for-profit organizations are dependent on the grants they receive from private foundations. If the amount that private foundations will award to such organizations is linked to investment returns in a given year, then these grant recipients and those they serve are also at the mercy of equity market return fluctuations. The cruel irony of this reality is that periods when the economy is performing poorly are when the most people are in need and the organizations that serve them are most dependent on private foundation support. Yet it is during such periods that the application of the 5% distribution rate will yield the smallest required distribution.

Actions Steps for Managing Foundation Distributions

When considering responses for addressing private foundation distribution challenges, it should first be noted that simply refusing to make the required 5% distribution is NOT a viable solution. As noted above, the penalty excise tax for failing to make the required distribution is 30% as the initial tax and an additional 100% if not timely corrected. So private foundations ultimately are forced to part with this distribution one way or the other.

There are, however, some common sense action steps that private foundations can take to minimize the impact that wide swings in investment returns will have on required distributions:

As was noted above, the 5% distribution requirement contains a carryforward provision. In other words, if a foundation distributes more than 5% in one year, it may apply these excess distributions against required distributions for the next five tax years, thus making it possible to distribute less than 5% in those future years. Thus, private foundations may wish to work towards building up a “reserve” of excess distributions during years in which investment returns are especially high. This would give the private foundation flexibility to make smaller distributions in years in which investment returns are poor.

Private foundations should revisit their investment spending policies, and consider whether adopting a spending policy that calculates the amount to be distributed based on a rolling average of the value of the foundation’s assets over the last several years might be appropriate. According to a 2010 research publication by Bernstein Global Wealth Management entitled Smarter Giving for Private Foundations, only 39% of private foundations even have a formal, written spending policy, and 59% of small private foundations report that their spending calculation consists of simply multiplying 5% by the prior year’s assets. Utilizing a more formal spending policy may allow the private foundation to manage distributions from year to year while still planning ahead to meet the 5% distribution requirement.

Private foundations should carefully manage the grant commitments that they make to recipient organizations. Ideally, grant commitments should be based on the distributions that foundation would plan on making during a year of poor investment returns. Thus, if investment returns turn out to be exceptionally good in a given year, the foundation will have extra, unanticipated income to make additional one-time grant disbursements. This is certainly preferable to the alternative, where private foundations find that they have made more grant commitments then can be satisfied during a year of poor investment returns.

Private foundations and their tax advisors should pay careful attention to how expenses are classified on Part I of the Form 990-PF. In general, foundation expenses are classified in Part I as either reductions of net investment income or disbursements for charitable purposes. As discussed earlier, the expenses classified as disbursements for charitable purposes count toward the foundation’s required distribution for the year, even if they do not constitute direct grant awards to recipient entities. Thus, private foundations should make sure that all expenses that relate to the foundation’s charitable mission (e.g., salary expense for individuals working on the foundation’s charitable endeavors, expenses for meetings at which grant distributions are discussed, etc.) are properly classified as disbursements for charitable purposes, so that the foundation may take credit for these when determining whether required distributions for the year have been met.

Conclusion

The 5% distribution requirement is an investment planning and grant-making challenge that is unique to private foundations. If addressed reactively and without forethought, this requirement has the potential to complicate the grant-making process and thereby frustrate private foundation trustees, employees and beneficiaries alike. However, if addressed proactively through the action steps described above, private foundations can satisfy their distribution requirements under tax law while still providing consistent, reliable assistance to not-for-profit organizations and those they serve.

Any federal tax advice contained in this communication (including any attachments): (i) is intended for your use only; (ii) is based on the accuracy and completeness of the facts you have provided us; and (iii) may not be relied upon to avoid penalties.